The following invention relates to a system and method for trading securities and, in particular, for a system and method of trading securities in pairs.
A recognized strategy for trading securities is known as pair-trading. Pair-trading is a non-directional investment strategy in which the investor identifies two securities having similar characteristics and the securities are currently trading at a price relationship that is out of their historical trading range. The investor exploits the price relationship between the securities by buying the undervalued security while short-selling the overvalued security. Because pair-trading is a market-neutral strategy, it is a particularly desirable strategy for investing in volatile markets.
One context in which pair trading is useful is where an investor desires to take advantage of an arbitrage opportunity resulting from a merger between two companies. For example, Company A has announced a definitive agreement to acquire Company T in which case Company T shareholders will receive 0.5 shares of Company A stock for each share of Company T stock they own. The investor desires to capture the “spread” between the offered consideration (0.5 shares of A) and the price of T stock. To do this, the investor buys shares in T stock and sells shares of A stock.
For instance, if stock T is trading at $28 per share and stock A is trading at $60 per share, then the investor may execute a trade for 200,000 spreads by buying 200,000 shares of T stock and selling 100,000 shares of A stock. After the merger takes place, the investor will cover the short position in stock A with the 100,000 shares of A stock the investors receives in exchange of the 200,000 shares the investor held of stock T. Thus, by executing the pair trade, the investor locks in a $400,000 profit (assuming that the merger goes through). The process of executing a pair trade thus includes executing individual trades directed to each leg of the pair trade request. An example of a system for executing trades for filling a pair trade request is the Quantex system from ITG (http://www.itginc.com/products/quantex/quantex.html) of 380 Madison Avenue, New York, N.Y. 10017.
A challenge in implementing a pair trade is to find a counterparty for a particular position an investor desires to establish while minimizing “leg risk.” Typically, a large pair trade is performed “off the market” as a private transaction negotiated by a financial institution that services large clients. For example, if an investor desires to execute a pair trade betting that a proposed merger between two companies will go through, the investor would approach a financial institution seeking an investor that is willing to bet against the merger. The financial institution then acts as an intermediary between the two investors in which the investors establish equal and opposite positions in the stock of the proposed merger partners thereby completing the pair trade. Thus by matching two pair trade requests so that the transactions associated with each of the pair trade legs are executed simultaneously, neither investor is exposed to leg risk that would otherwise result for the period of time between execution of the first leg and the second leg of the pair trade.
There are numerous drawbacks associated with the prevalent pair-trading practice. First, pair-trading is typically limited to clients of large financial institutions that have the ability to identify suitable counterparties for a particular pair trade. This is especially the case when the pair trade involves a large amount of stock or illiquid stocks in which the only way to execute the trade and minimize leg risk is via an “off the market” transaction negotiated by a financial institution. Also, because a pair-trade is typically negotiated by the parties with a financial institution as an intermediary, the process is often slow and inefficient. Furthermore, pair-trading under current practice is generally best suited for large clients seeking to establish large positions thereby providing the financial institutions with the economic incentive to execute the transaction. Smaller clients, however, must rely on the markets for executing pair trades, which is unsuitable for illiquid stocks and also results in increased leg risk.
Accordingly, it is desirable to provide a system and method for trading securities in pairs.